Butterfly Spread

What Is a Butterfly Spread?

A butterfly spread is an options strategy combining bull and bear spreads, with a fixed risk and capped profit. These spreads, involving either four calls or four puts are intended as a market-neutral strategy and pay off the most if the underlying does not move prior to option expiration.

Key Takeaways

There are multiple butterfly spreads, all using four options.

All butterfly spreads use three different strike prices.

The upper and lower strike prices are equal distance from the middle, or at-the-money, strike price.

Each type of butterfly has a maximum profit and a maximum loss.

Understanding Butterflies

Butterfly spreads use four option contracts with the same expiration but three different strike prices. A higher strike price, an at-the-money strike price, and a lower strike price. The options with the higher and lower strike prices are the same distance from the at-the-money options. If the at-the-money options have a strike price of $60, the upper and lower options should have strike prices equal dollar amounts above and below $60. At $55 and $65, for example, as these strikes are both $5 away from $60.

Puts or calls can be used for a butterfly spread. Combining the options in various ways will create different types of butterfly spreads, each designed to either profit from volatility or low volatility.

Long Call Butterfly

The long butterfly call spread is created by buying one in-the-money call option with a low strike price, writing two at-the-money call options, and buying one out-of-the-money call option with a higher strike price. Net debt is created when entering the trade.

The maximum profit is achieved if the price of the underlying at expiration is the same as the written calls. The max profit is equal to the strike of the written option, less the strike of the lower call, premiums, and commissions paid. The maximum loss is the initial cost of the premiums paid, plus commissions.

Short Call Butterfly

The short butterfly spread is created by selling one in-the-money call option with a lower strike price, buying two at-the-money call options, and selling an out-of-the-money call option at a higher strike price. A net credit is created when entering the position. This position maximizes its profit if the price of the underlying is above or the upper strike or below the lower strike at expiry.

The maximum profit is equal to the initial premium received, less the price of commissions. The maximum loss is the strike price of the bought call minus the lower strike price, less the premiums received.

Long Put Butterfly

The long put butterfly spread is created by buying one put with a lower strike price, selling two at-the-money puts, and buying a put with a higher strike price. Net debt is created when entering the position. Like the long call butterfly, this position has a maximum profit when the underlying stays at the strike price of the middle options.

The maximum profit is equal to the higher strike price minus the strike of the sold put, less the premium paid. The maximum loss of the trade is limited to the initial premiums and commissions paid.

Short Put Butterfly

The short put butterfly spread is created by writing one out-of-the-money put option with a low strike price, buying two at-the-money puts, and writing an in-the-money put option at a higher strike price. This strategy realizes its maximum profit if the price of the underlying is above the upper strike or below the lower strike price at expiration.

The maximum profit for the strategy is the premiums received. The maximum loss is the higher strike price minus the strike of the bought put, less the premiums received.

Iron Butterfly

The iron butterfly spread is created by buying an out-of-the-money put option with a lower strike price, writing an at-the-money put option, writing an at-the-money call option, and buying an out-of-the-money call option with a higher strike price. The result is a trade with a net credit that’s best suited for lower volatility scenarios. The maximum profit occurs if the underlying stays at the middle strike price.

The maximum profit is the premiums received. The maximum loss is the strike price of the bought call minus the strike price of the written call, less the premiums received.

Reverse Iron Butterfly

The reverse iron butterfly spread is created by writing an out-of-the-money put at a lower strike price, buying an at-the-money put, buying an at-the-money call, and writing an out-of-the-money call at a higher strike price. This creates a net debit trade that’s best suited for high-volatility scenarios. Maximum profit occurs when the price of the underlying moves above or below the upper or lower strike prices.

The strategy’s risk is limited to the premium paid to attain the position. The maximum profit is the strike price of the written call minus the strike of the bought call, less the premiums paid.

Example of a Long Call Butterfly

An investor believes that Verizon stock, currently trading at $60 will not move significantly over the next several months. They choose to implement a long call butterfly spread to potentially profit if the price stays where it is.

An investor writes two call options on Verizon at a strike price of $60, and also buys two additional calls at $55 and $65.

In this scenario, an investor would make the maximum profit if Verizon stock is priced at $60 at expiration. If Verizon is below $55 at expiration, or above $65, the investor would realize their maximum loss, which would be the cost of buying the two wing call options (the higher and lower strike) reduced by the proceeds of selling the two middle strike options.

If the underlying asset is priced between $55 and $65, a loss or profit may occur. The amount of premium paid to enter the position is key. Assume that it costs $2.50 to enter the position. Based on that, if Verizon is priced anywhere below $60 minus $2.50, the position would experience a loss. The same holds true if the underlying asset were priced at $60 plus $2.50 at expiration. In this scenario, the position would profit if the underlying asset is priced anywhere between $57.50 and $62.50 at expiration.

This scenario does not include the cost of commissions, which can add up when trading multiple options.

Long Put

What Is a Long Put?

A long put refers to buying a put option, typically in anticipation of a decline in the underlying asset. A trader could buy a put for speculative reasons, betting that the underlying asset will fall which increases the value of the long put option. A long put could also be used to hedge a long position in the underlying asset. If the underlying asset falls, the put option increases in value helping to offset the loss in the underlying.

Key Takeaways

Investors go long put options if they think a security’s price will fall.

Investors may go long put options to speculate or hedge a portfolio.

Downside risk is limited using a long put options strategy.

The Basics of a Long Put

A long put has a strike price, which is the price at which the put buyer has the right to sell the underlying asset. Assume the underlying asset is a stock and the option’s strike price is $50. That means the put option entitles that trader to sell the stock at $50, even if the stock drops to $20, for example. On the other hand, if the stock rises and remains above $50, the option is worthless because it is not useful to sell at $50 when the stock is trading at $60 and can be sold there (without the use of an option).

If a trader wishes to utilize their right to sell the underlying at the strike price, they will exercise the option. Exercising is not required. Instead, the trader can simply exit the option at any time prior to expiration by selling it.

A long put option may be exercised before the expiration if it’s an American option whereas European options can only be exercised at the expiration date. If the option is exercised early or expires in the money, the option holder would be short the underlying asset.

Long Put Strategy Versus Shorting Stock

A long put may be a favorable strategy for bearish investors, rather than shorting shares. A short stock position theoretically has unlimited risk since the stock price has no capped upside. A short stock position also has limited profit potential, since a stock cannot fall below $0 per share. A long put option is similar to a short stock position because the profit potentials are limited. A put option will only increase in value up to the underlying stock reaching zero. The benefit of the put option is that risk is limited to the premium paid for the option.

The drawback to the put option is that the price of the underlying must fall before the expiration date of the option, otherwise, the amount paid for the option is lost.

To profit from a short trade a trader sells a stock at a certain price hoping to be able to buy it back at a lower price. Put options are similar in that if the underlying stock falls then the put option will increase in value and can be sold for a profit. If the option is exercised, it will put the trader short in the underlying stock, and the trader will then need to buy the underlying stock to realize the profit from the trade.

Long Put Options to Hedge

A long put option could also be used to hedge against unfavorable moves in a long stock position. This hedging strategy is known as a protective put or married put.

For example, assume an investor is long 100 shares of Bank of America Corporation (BAC) at $25 per share. The investor is long-term bullish on the stock, but fears that the stock may fall over the next month. Therefore, the investor purchases one put option with a strike price of $20 for $0.10 (multiplied by 100 shares since each put option represents 100 shares), which expires in one month.

The investor’s hedge caps the loss to $500, or 100 shares x ($25 – $20), less the premium ($10 total) paid for the put option. In other words, even if Bank of America falls to $0 over the next month, the most this trader can lose is $510, because all losses in the stock below $20 are covered by the long put option.

Real World Example of Using a Long Put

Let’s assume Apple Inc. (AAPL) is trading at $170 per share and you think it’s going to decrease in value by about 10% ahead of a new product launch. You decide to go long 10 put options with a strike price of $155 and pay $0.45. Your total long put options position outlay cost is $450 + fees and commissions (1,000 shares x $0.45 = $450).

If the share price of Apple falls to $154 before expiry, your put options are now worth $1.00 since you could exercise them and be short 1,000 shares of the stock at $155 and immediately buy it back to cover at $154.

Your total long put options position is now worth $1,000 – fees and commissions (1,000 shares x $1.00 = $1,000). Your profit on the position is 122% ($450/$1,000). Going long put options allowed you to realize a much greater gain than the 9.4% fall in the underlying stock price.

Long Butterfly Spread w/Calls

The Strategy

A long call butterfly spread is a combination of a long call spread and a short call spread, with the spreads converging at strike price B.

Ideally, you want the calls with strikes B and C to expire worthless while capturing the intrinsic value of the in-the-money call with strike A.

Because you’re selling the two options with strike B, butterflies are a relatively low-cost strategy. So the risk vs. reward can be tempting. However, the odds of hitting the sweet spot are fairly low.

Constructing your butterfly spread with strike B slightly in-the-money or slightly out-of-the-money may make it a bit less expensive to run. This will put a directional bias on the trade. If strike B is higher than the stock price, this would be considered a bullish trade. If strike B is below the stock price, it would be a bearish trade. (But for simplicity’s sake, if bearish, puts would usually be used to construct the spread.)

Options Guy’s Tip

Some investors may wish to run this strategy using index options rather than options on individual stocks. That’s because historically, indexes have not been as volatile as individual stocks. Fluctuations in an index’s component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.

The Setup

Buy a call, strike price A

Sell two calls, strike price B

Buy a call, strike price C

Generally, the stock will be at strike B

NOTE: Strike prices are equidistant, and all options have the same expiration month.

Who Should Run It

Seasoned Veterans and higher

NOTE: Due to the narrow sweet spot and the fact you’re trading three different options in one strategy, butterfly spreads may be better suited for more advanced option traders.

When to Run It

Typically, investors will use butterfly spreads when anticipating minimal movement on the stock within a specific time frame.

Maximum Potential Loss

Ally Invest Margin Requirement

As Time Goes By

For this strategy, time decay is your friend. Ideally, you want all options except the call with strike A to expire worthless with the stock precisely at strike B.

Implied Volatility

After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.

If your forecast was correct and the stock price is at or around strike B, you want volatility to decrease. Your main concern is the two options you sold at strike B. A decrease in implied volatility will cause those near-the-money options to decrease in value, thereby increasing the overall value of the butterfly. In addition, you want the stock price to remain stable around strike B, and a decrease in implied volatility suggests that may be the case.

If your forecast was incorrect and the stock price is approaching or outside of strike A or C, in general you want volatility to increase, especially as expiration approaches. An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strike B, thereby increasing the overall value of the butterfly.

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